Few understand the ways of the herd better than Robert Arnott, founder of index provider Research Affiliates of California. A 1977 triple major in economics, applied mathematics and computer science at the University of California, he developed skills in tactical asset allocation that helped him to build not one, but two, asset management firms.

Photo credit: Natalie Brasington

His first, TSA Capital Management, oversaw $3 billion when he left in 1987. His second, First Quadrant, ran $18 billion by 2002.

Arnott could have become a hedge fund manager worth billions. But his passion still lies in academic research.

Where hedge fund managers shrink from the world stage, Arnott strides across it. Over the years, he has published more than 100 scholarly articles, often poking fun at the folly of accepted wisdom, and in 2008 co-authored a book, The Fundamental Index: A Better Way to Invest.

Research Affiliates has earned renown for its fundamental smart beta indices, which rank companies according to their sales, cashflow, book worth and dividends, as opposed to traditional indices, which use market values.

Traditional indices tend to lag RA’s fundamental series by two percentage points a year because they are weighted towards overpriced growth stocks pushed up in value by the thundering herd which then plunge.

Arnott said: “Fundamental indices work because they break the link between price and weight in the portfolio.”

More recently, Arnott has been delving into target-driven defined contribution plans. He has discovered the way managers choose to invest on behalf of their clients is badly flawed.

He said: “We have allowed a $1 trillion business to be built on the basis of zero research. We need a political debate to try to put sense into the way people save for their retirement.”

Arnott’s beef concerns the way money gets invested on behalf of people using target-driven and lifestyle DC plans.

The precise mechanics of each vary, but they both invest in equities early on, switching to bonds over time so clients can get a fix on the size of their pensions.

So far, no good, says Arnott, whose analysis of performance data has proved, time and again, that people are investing the wrong way round.

Rather than switching from equities to bonds, he said, they should move from bonds to equities: “The inverse glide path beats the standard approach relentlessly.”

He has analysed different styles over 40-year periods, equivalent to the length of a DC plan, since 1871, to compare how the switches between bonds and equities performed in different cycles.

In each case, he assumes that an individual is contributing $1,000 a year to a plan in real terms.

The conventional switch from an 80% equity weighting to 20% produces an average retirement pot of $124,460. But an inverse switch from a 20% equity weighting to 80% would generate $152,060.

The worst outcome for conventional DC would be $49,940 against $53,000 for inverse DC. The best would be $211,300 for conventional against $287,000 for inverse.

Research carried out by Javier Estrada of Barcelona’s IESE Business School observed a similar pattern in 19 countries.

Inverse DC

Even after making some exceptionally gloomy forecasts on future equity returns, Arnott has calculated that inverse DC will continue to perform best.

Why so? Arnott says investors using the inverse approach are putting the maximum possible amount of money into return-seeking assets, while conventional DC avoids doing so. Arnott said: “The equity risk premium only works when you have serious money invested.”

He is equally critical of the way people are expected to switch to bonds, when their yield is thin, as is the case right now. “Buying debt at a negative real yield is not a great idea,” he said.

He argues, however, that younger savers should be more prepared to buy bonds, to save them from small, but painful, losses in their early years.

Losses in the equity market all too easily persuade them never to save again. “In the US, 45% of DC pensions get cashed out by young people when they change jobs,” he said, noting that a bad economic environment is likely to coincide with low equity values. This means young people losing their jobs in a recession would be more tempted to cash in their pensions when equity values are low, losing out twice.

Nest, the DC system sponsored by the UK government, has accepted some of this thinking by putting limits on risks for young savers for five years. According to its website: “We aim to avoid sharp falls in value and work towards a steadily growing balance to encourage members to save.”

The Swedish government encourages providers to take account of generous state benefits. With 87% of retirement income now safe, it has allowed members to access a leveraged equity fund, which has produced 60%, or triple the average fund, since 2010.

In urging a broader DC rethink, however, Arnott does not want investors to automatically default to mainstream US equities. In his view, they should access a broader range of assets, which he calls a “third pillar”.

He argues western markets are heading into a period where people are ageing and dropping out of the workforce.

He said: “You end up with a prosperous economy that is growing slowly. That’s OK, but you can get an expectation gap. Politicians trying to increase growth end up creating an illusion of prosperity by borrowing from our future.”

His stance mirrors the thinking of Bill Gross, chief investment officer at Pimco, who has often criticised high levels of US government debt.

Debt servicing, currency debasement and inflation will surely result from indebtedness, said Arnott. He added that people are being fooled by consumer price indexation which plays down the impact of four basic needs: housing, fuel, food and healthcare.

Over the past four years, their inflation was nearly 4% against 1.5% from the official CPI, based on official data, which could flatter the result. He said: “CPI is probably the most worthless statistic ever produced, other than GDP.”

‘Third pillar’ assets

To protect their DC pensions, he said investors should put their faith in a package of “third pillar” assets, comprising cheap assets away from the western mainstream capable of providing protection against the rising cost of living.

The All Asset product Arnott manages for Pimco fits the bill. Its portfolio has generated an annualised 8.6% since inception in 2002. This compares with 5.1% from the 10-year Barclays index-linked bond index and 7.8% from a portfolio of Lipper funds used as a comparison by Pimco marketing documents.

Over one year the fund has done a little less well against Lipper. Most of RA’s fundamental indices are performing well enough, although a few of them, such as high yield and emerging markets, are lagging traditional indices over the short term, as the herd pushes prices down, or up, excessively.

According to analysts, the All Asset fund is currently taking a big bet on emerging markets.
Arnott argues emerging markets ratings are exceptionally cheap, as a result of the withdrawal of liquidity.
Their countries, in aggregate, are better financed than the west.

Their demographics are attractive, with populations heading into their 30s, an exceptionally productive age, as people settle down and work for their families. Arnott said: “Governments can always screw things up, but collectively, emerging markets will be fine.”

Arnott also urges investors to take a view on equity markets through his fundamental indices.

And sales of smart beta products, including exchange-traded funds based on his indices, are breaking records.

Arnott said: “We’re on a great adventure in which we have developed an important new idea. It’s fun to watch it gain traction.”

Then he paused and shook his head: “There is astonishing inertia in our business…”

This article was first published in the print edition of Financial News dated July 14, 2014